Why tech stocks deserve to be cheaper than industrials

By Felix Salmon

July 25, 2011

buysidemetrics for finding this very smart quote from Bill Gates, which actually comes from a discussion he had with Warren Buffett in 1998: "
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Many thanks to commenter buysidemetrics for finding this very smart quote from Bill Gates, which actually comes from a discussion he had with Warren Buffett in 1998:

BUFFETT: The technological revolution will change the world in dramatic ways, and quickly. Ironically, however, our approach to dealing with that is just the opposite of Bill’s. I look for businesses in which I think I can predict what they’re going to look like in ten or 15 or 20 years. That means businesses that will look more or less as they do today, except that they’ll be larger and doing more business internationally.

So I focus on an absence of change. When I look at the Internet, for example, I try and figure out how an industry or a company can be hurt or changed by it, and then I avoid it. That doesn’t mean I don’t think there’s a lot of money to be made from that change, I just don’t think I’m the one to make a lot of money out of it.

Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people are going to chew gum. Bill probably does. I don’t think it’s going to change the fact that Coke will be the drink of preference and will gain in per capita consumption around the world; I don’t think it will change whether people shave or how they shave. So we are looking for the very predictable, and you won’t find the very predictable in what Bill does. As a member of society, I applaud what he is doing, but as an investor, I keep a wary eye on it.

GATES: This is an area where I agree strongly with Warren. I think the multiples of technology stocks should be quite a bit lower than the multiples of stocks like Coke and Gillette, because we are subject to complete changes in the rules.

This I think is the heart of the reason why technology stocks are trading at lower multiples than industrials. There’s no doubt that in an era of massive change, there will be a handful of tech companies which are huge winners. On the other hand, there will be some giant tech companies which are big losers, too. (Just see the fate of Apple since 1998, and compare it to the fate of Microsoft.) In general, if the number of losers exceeds the number of winners, or if the winners start out small and the losers start out big, then that’s a sector you’d be smart to buy only at relatively low multiples.

Meanwhile, in an area where change is unlikely to massively disrupt your business, income streams are more predictable and therefore more valuable.

Another way to look at this is to take the simple but powerful heuristic that the expected lifespan of any company is twice its current age. Wrigley’s and Coke and Gillette have been around a lot longer than Microsoft or Apple or Facebook, and there’s a very good chance that they’ll still be here when the current tech stars are distant memories. If I had to buy one asset for the ultra-long term — something on the order of a few hundred years — then I’d probably end up buying a timber forest: those things last forever, with growth that is so steady and predictable that it’s literally a science, and yields which can easily be stored up during periods of market weakness (just by cutting down fewer trees).

So then the next question arises: why are tech companies trading lower than industrials now, when they’ve never done so in the past? Has the market suddenly become uncharacteristically rational?

That’s a harder question to answer, but I think that it’s fundamentally based on the fact that the giants of the dot-com era are still big and entering a long-term decline — think Microsoft, or Intel, or HP, or Yahoo. Meanwhile, the exciting smaller companies, insofar as they exist, simply aren’t public.

And it turns out that even Warren Buffett’s boring and predictable companies like Coca-Cola can benefit from huge and unpredictable trends. Mark Bittman has a good piece in this weekend’s NYT which included this chart:

I don’t think that anybody — not even Warren Buffett — could have predicted 30 years ago that soda price inflation would so massively lag both consumer prices generally and food prices in particular. Healthy food is now twice as expensive, relative to soda, as it was in the early 80s. Which obviously does wonders for Coca-Cola’s brand franchise, even if it causes billions of dollars a year in damage elsewhere in the economy. If I’m a long-term buy-and-hold investor, that’s the kind of trend I want to jump on. Rather than, say, Farmville. To make money in Zynga stock you need to know when to sell. To make money in Coca-Cola stock, you don’t.